Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Friday, June 24, 2011

Bitcoin

Bitcoin is a form of cyber-money that has been with us since 2009. In order to understand it, and why it may or may not be interesting, it helps to review other more or less conventional monetary arrangements. The three I've chosen, as each shares something with bitcoin, are commodity money, fiat money, and private money.

Commodity moneyThe earliest forms of money were commodity monies, primarily gold and silver. It's not hard to see why gold makes a good commodity money. It is scarce, it is difficult to replicate (i.e. counterfeit), and it is relatively easy to carry around, at least in the quantities one would need to make day-to-day transactions. The scarcity comes from the fact that it is costly to dig the gold out of the ground, and its physical characteristics make counterfeiting costly as well. These properties of gold of course did not prevent people from trying to scam the system. Alchemists tried in vain to create gold out of nothing (or, one step up, urine), and counterfeiting and debasement made quality-monitoring necessary.

Commodity money systems were not without their costs. If gold is used as money, then its value in exchange causes its price in terms of goods and services to be higher than it would otherwise be. There is a "gold bubble" in the sense that gold trades at a price higher than it would if gold were used only as an input in production or for consumption purposes. This higher price of gold makes it more profitable to dig the stuff out of the ground, so there is a resource cost to society of supporting the monetary system. Another problem is that, under a commodity money system, we are at the mercy of changes in technology or in the demand for the commodity for other purposes than as money. For example, if gold is used as money, then a better technology for extracting gold from the ground, or a reduction in the demand for gold jewelry, will reduce the price of gold relative to other goods and services. This is inflation of course, which we know is socially costly.

Fiat MoneyModern-day fiat money evolved by way of commodity-backed paper money (e.g. the gold standard). In the US, Federal Reserve notes are not explicit promises to pay anything in the future; the Fed will not redeem the currency it issues in the form of some other commodity or asset. Things are a little tricky though, as the Fed actually lists currency as one of the items on the liability side of its balance sheet, and there are indeed assets on the other side of the balance sheet that represent backing for the Federal Reserve notes. Indeed, the Fed does not create the notes "out of thin air" but issues them in exchange for other assets, which are typically obligations of the US Treasury (though some other stuff currently appears on the asset side of the Fed's balance sheet). Thus, there is a sense in which Federal Reserve notes are ultimately backed by the power of the US government to tax us.

A fiat money standard potentially eliminates some of the costs of a commodity money system. First, paper is cheap to produce and, second, we can solve the problem of price level stability if we can trust the issuer of fiat money to manage the stock of the stuff appropriately. However, we are now faced with some new problems. Counterfeiting now becomes potentially much more severe, which is clearly why it took so long for fiat money systems to evolve. We had to wait for a good anti-counterfeiting technology to arrive. Once it did, the government needed to work continuously to keep one step ahead of the counterfeiters. A good anti-counterfeiting technology is one which makes it very low cost for the average person to tell the difference between a counterfeit and the real thing, and makes it very high cost for a counterfeiter to replicate the real thing (and obviously these two things are related).

Another problem with a fiat money system is that we now have to support an elaborate structure for managing the money supply and monitoring the money-supply managers. The cost of operating the Federal Reserve System and checking up on what it is doing is clearly significant. Sometimes fiat money systems do not work so well, and we get phenomena like this.

Private MoneyThere are plenty of examples of the use of circulating private money, typically issued by banks. During the US "free banking era," 1837-1863, state-chartered banks issued small-denomination pieces of paper that were the dominant media of exchange. This era was somewhat chaotic, with many attendant problems, though the success of the system is subject to some debate. Well-functioning private money systems existed in Scotland in the early 19th century and in Canada before 1935. Private money issue in these systems was by no means a free-for-all, as there were well-established rules under which note-issuing banks operated. In the Canadian system for example, it was difficult to obtain a bank charter with note-issuing privileges, the notes were required to be redeemable in gold, and notes were required to be senior claims on the bank's assets. There are modern examples of private monies in North America, which I think we could categorize as curiosities. These include Canadian Tire money and Ithaca Hours.

BitcoinNow, to get to the point, what is Bitcoin? The orgins of this cyber-money are somewhat obscure, as the author of the underlying code apparently chooses to remain anonymous. Bitcoin is exchanged on an anonymous person-to-person network, which anyone can join by downloading the relevant software from here. The stuff is created essentially by solving a puzzle. I can solve it, you can, or Justin Beiber can solve it, given enough computing power and time. There is nothing creative about solving the puzzle, but it is costly as it burns power (see this) and occupies computing capacity. Further, in creating new bitcoins I have to do some checking of previous transactions on the network, which is in part how good behavior is enforced. A bitcoin is then a string of bits, and it can be traded.

The Bitcoin web site claims that some people are willing to accept bitcoins in exchange for goods and services, and some are willing to exchange bitcoins for US dollars (and presumably other currencies). The algorithm is designed so that solving puzzles becomes progressively more difficult, which targets the growth path of bitcoins so that the quantity converges to 21 million in about 2140.

Bitcoins share some of the features of a commodity money, in that there is a natural scarcity - the stuff is hard to produce. This comparison helps us think about some of the potential problems as well. What prevents modern-day alchemists from coming up with a way to replicate a bitcoin? Success certainly seems much more likely than for the old-time alchemists, since the bitcoin algorithm was created by a human being. All it takes is a smarter human being to beat it.

A bitcoin is also somewhat like fiat money, in that it is not redeemable. However, in contrast to central bank money, there are no assets backing the stuff. Further, while I can identify Fed officials, and I know how they are appointed, I have no idea who invented bitcoin. How do I know the inventor does not have a second set of software that will allow him to claim all the seignorage when he or she thinks the time is right? While libertarians appear to be attracted by the idea, I don't think the general public will take well to a medium of exchange for which we can't hold anyone responsible. Certainly these people have a problem with it.

One sense in which bitcoins differ dramatically from fiat money is in terms of the anonymity of the transactions. One of the virtues of currency (and also one its downfalls, since this makes it easy to steal) is that it is very low-tech and easy to transfer, and lacks memory. While there is a sense in which the bitcoin network is anonymous, in another sense it is most definitely not. The system tracks the machines on which the bitcoins reside, and appears to record the entire history of such residence.

Like historical private money systems, bitcoin involves a system of private issuers, but the private money systems I discussed above operated within a well-defined legal framework. Any system of monetary exchange requires enforceable rules concerning contracts, and bitcoin has none of this. Further, Timothy Lee, who appears to know what he is talking about, sees a potential collusion problem in the bitcoin system. Whether this is any worse a problem than what existed, for example, in the Canadian banking system pre-1935, I'm not sure.

In spite of the fact that I think bitcoin is a curiosity, on the order of Canadian Tire money or Ithaca Hours, it would be wrong to criticize it for being a "pyramid scheme," or a "bubble." Indeed, modern fiat money is both of those things. One could imagine getting a fiat money system off the ground and observing time series of prices for the stuff that look much like what you can find here. As fiat money becomes more widely acceptable, its price in terms of goods and services rises, and people who "got in early" can make a profit. Fiat money is a bubble in the purest sense, in that its fundamental value is zero, but nevertheless people are willing to give up goods, services, and other assets in exchange for it. Bubbles can be good things, as any asset which is used widely in exchange will trade at a price higher than its "fundamental," and the asset's liquidity premium - the difference between the actual price and the fundamental - is a measure of the asset's social contribution as a medium of exchange.

24 comments:

Great post Stephen. After all the two-way name calling in some other posts, this was very enjoyable. I actually learnt more from this single post than an hour long interview with Russ Roberts. Though I suspect, if I go back to that podcast now, it will make a lot more sense. Thanks again.

"The system tracks the machines on which the bitcoins reside, and appears to record the entire history of such residence."

This is highly misleading.While all transactions are recorded in the blockchain (consider it a public ledger) - it does not track machines. In fact a bitcoin address which can be deposited to, might have no machine associated with it whatsoever. The associated 'wallet' could be stored on an offline cd or even paper. This is done through the magic of public key cryptography.

I don't find the idea that base money is backed assets or taxpayer's money compelling. Central banks do in fact create this money out of thin air, essentially countlessly (indeed, isn't this the reason for the famous Friedman Rule, that nominal interest rates should be zero?). They then use this money to buy stuff, usually government securities but in principle they could buy anything. They could even just print currency and give it away, dropping it from helicopters. And there is nothing to say that the government won't default on its loans rendering the "taxpayer-backed" securities worthless.

The point is that holders of currency can't go to the Fed and get hold of the assets that supposedly back their currency. It's a bit like if I had a counterfeiting machine, printed a load of fake money, and went out and bought a load of jewelry. That wouldn't mean the fake money was backed by gold! And if the notes were indistinguishable from real money, they would be worth just as much, despite having been created out of thin air.

Thanks for the clarification. This illustrates a key point, which is that you have to be a computer geek to understand exactly how this works, so how do you get the average person to trust it. Of course the Fed is not necessarily transparent for the average person either (see the last anonymous, for example).

Last anonymous,

I think I know where you are coming from. Federal reserve notes do not "come out of thin air" any more than a corporate bond or corporate stock. This is for you:

"there is a sense in which Federal Reserve notes are ultimately backed by the power of the US government to tax us"

There is also "a sense" in which IBM stock is backed by IBM's assets and future earnings, and a sense in which NY City bonds are backed by NY City's assets. Of course, if you had been told all your life that stocks and bonds were not backed by anything, you could be forgiven for being a little tentative as you gradually came to realize that they really are backed by the assets of the entity that issued them, even if they are not currently convertible into some specific commodity.

So as you waver into the realm of the backing theory, I should just be glad that you are wavering in the right direction.

While I understand your analogy with stocks and bonds, I always found the expression "backed by the taxation power of the government" a bit confusing. I guess the reason is that what makes something money is that, unlike stocks, its value derives mainly from the liquidity services it provides and not from, say, the expected stream of future dividends associated with it. From this perspective, fiat money is backed not so much by the power of the government to tax, or the fact that the Central Bank holds assets that it bought with the money it created, but by the ability of the government or the Central Bank to commit not to indulge in too much seignoriage, thus undermining the liquidity services that money provides. I suppose the power to tax or holding assets comes in handy to make this commitment cheaper and as such it "backs the value of the currency". But isn't it rather indirect?

Yes, the liquidity services of money are important, but the implicit promises made by the central bank can be critical for how it is valued. For example, suppose the central bank makes an open market purchase of government debt, with the promise that it will reverse this in the future. The money stock goes up, then it goes back down, but under some conditions this could have no effect on any quantities or prices. However, it is possible that the market value of the government debt falls before the money injection is reversed, in which case the central bank cannot literally reverse it, and so the price level goes up. In the worse case suppose that, after the initial open market purchase takes place, that the government defaults on the debt that the central bank is holding. Then, the open market operation cannot be reversed, the money is out there forever, and the price level goes up. Backing is important, as this has something to do with the implicit promises to pay or the "fundamental" that is also determining the value of money, in addition to the value of liqudity services captured in the liquidity premium.

You have said that Federal Reserve Notes are "backed" by assets on the Fed's balance sheet. This implies a 100% backing of all outstanding currency. But, since we have fractional reserve banking, isn't the backing only fractional? In other words, if the Fed were liquidated today, wouldn't the dollar value of all the assets on the balance sheet only amount to a fraction of the total dollar value of the entire money supply (given the effect of the money multiplier in a fractional reserve system)?

it is simply not so. Bonds and stock are not used to buy and sell. If I print fake money is that backed by what I buy? Tell me why I should go to jail then.

Notice that if the central bank prints money and promises to shrink the money supply in the future that is not neutral: money does not fall from the sky therefore redistruntes wealth, alters relative pricesUnfortunately is a big mistake by the mainstream to assess the effect of money printing the aggregate

Anon 10:59 AM: "This implies a 100% backing of all outstanding currency. But, since we have fractional reserve banking, isn't the backing only fractional? ... only amount to a fraction of the total dollar value of the entire money supply"

Steve is probabaly busy enjoying his Sunday so I will take a crack at this.

Yes and no.

You understand that the monetary base -- currency plus reserves -- is only a fraction of the money supply, which includes demand deposits. Right?

You also probably have heard that if the monetary base is increased by $1 million and the money multiplier is 10, for example, then the money supply goes up by $10 million. Right?

If the Fed were liquidated and all dollars were repurchased with the assets that the Fed holds -- mostly Treasuries -- the money supply would shrink by $10 for each $1 in Treasuries that the Fed sold. The reason that it would do so is that the fractional reserve system would work in reverse. Each Fed asset sale would cause commercial banks to make many fewer loans and would reduce the money supply much more (10x more) than the Fed sale.

So, it is true that the Fed's assets only "back" the monetary base, not the whole money supply but their sale could be used to retire the whole monetary base, which would retire the whole money supply.

"But, since we have fractional reserve banking, isn't the backing only fractional?"

1. You are confusing private liabilities with Fed liabilities. I was only talking about the liabilities the Fed issues.2. We actually do not have a fractional reserve banking system in the United States. In normal times, reserve requirements essentially do not bind, as banks have found various mechanisms, including sweep accounts, for getting around them.

you buy bonds and stocks using money. You don't shop around using stocks and bonds. Din, din...got it?:-) Is that so complex to understand what Adam Smith understood almost 300 years ago? If you don't believe me go and try to buy a car exchanging it for a bond

You are saying that (FED) money is backed by something. Tell me why I end up in jail if I print money and use it to "back" my purchases as the FED does. Any comment?

You are telling others "I know where you are coming from". I guess where you come from too: from the FED money ...no matter what your mother says:-)

Let me conclude that is a shame whet is currently spammed as economics science

1. Retail exchange is not everything. Other types of transactions, for example interbank payments, are very important too, and many assets, intermediated in various ways are important in supporting those transactions. That's critical if you want to understand the financial crisis or unconventional monetary policy.

3. Some libertarians view the Fed as some grand conspiracy. It has its problems, but its just another of our institutions that allow us to work together to solve some serious problems, and I think the Fed is appropriately constrained by the democractic process. You can go off and live in the woods if you want, but the rest of us find it useful to work collectively sometimes.

4. There is hope for you yet. Try to keep up with the science, and channel that misplaced anger into something productive.

1. first of all you admit that what you say is totally false with reagard to retail trades: bonds and stocks are not money but exchanged against money. However in your wholesale fantastic world bonds are issued and exchanged not to raise money. What for? Beers? When stocks are exchanged for other stocks (which doesn't seems to be so often) how their respective values are measured? How they got into circulation? (Hint: to raise money)

2. I understand my self that is forbidden by laws printing FED notes. WHAT I'M ASKING YOU IS WHY, SINCE THOSE NOTES ARE BACKED BY WHAT I BUY EXACLTLY AS THE FED DOES.

3. Libertarians view the FED and any central banks as they are: inflationary, redistribuitive machines governed by politicians and their representatives which distort relative prices, inflate bubbles which sooner or later have to pop, finance welfare and warfare programs

4. the only hope you have is understanding the difference between savings and credit...which looks beyond your means :-)

"I understand my self that is forbidden by laws printing FED notes. WHAT I'M ASKING YOU IS WHY, SINCE THOSE NOTES ARE BACKED BY WHAT I BUY EXACLTLY AS THE FED DOES."

You're shouting something at me in upper case, that is both ungrammatical and nonsensical. When you ask a question, you have to do it in a way that makes the question understandable. Otherwise I can't answer it. Capisce?

Every one on earth undesrtands that printing money is a crime. It is not necessary that Mr Williamson reminds thatBut you say that there is nothing bad if the FED prints money because those notes are backed by government debt (...though it is not true). I am asking you why this does not apply to anyone but to the FED only. If you want I commit myself to buy US treasuries with what I've printed. :-)Where is the crime? Why if it is the FED that prints is ok and if I am the one that prints I end up into jail?

I came in a bit late on this, but I just wanted to point out that your concern about secret backdoors in the bitcoin software and hackers is unfounded. The source code is open source so anybody can inspect it's various functions and logic. It is also explained in layman's terms in the original design and on several websites. If you don't have the know-how to inspect the code yourself, you could take the word of a programmer that you trust, or simply assume that if there was a secret money grab in it, it would have been noticed by the many programmers who have gone over the code.

The generation of new money using computing power to secure current transactions is also devilishly clever. It means that as the value of the bitcoin goes up, so does the system security.

The computing problems used to verify transactions require brute-force solutions but are easily verifiable. For someone to make up a fake set of transactions, they would have to be solving these problems faster than everyone honest combined to be able to put in a false transaction history.

While debt is often secured against an asset, the asset value decreases when debt creation (ie: money creation) decreases. The relationship between asset prices and debt is bidirectional, and so there is no effective backing to the debt-money in circulation.

Bitcoin is a great idea, but it would need to be accompanied with regulation to tackle global trade imbalances I think.

"How do I know the inventor does not have a second set of software that will allow him to claim all the seignorage when he or she thinks the time is right?"

Because the source code is open. You are relying on the ability of anyone in the world to look at it and determine if there are problems. If problems within the source code are pointed out, everyone within the bitcoin network can choose to download the modified version with fixes. It is very unlikely that a single person or a limited group of people could have created such a covert operation that even with the under-workings of the entire network available to the scrutiny of the world, it would go unnoticed.

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